Square Inc (SQ) Stock Has Gone Too Far, Too Fast

SQ stock has a great growth story, but that's already priced in

At least CEO Jack Dorsey is doing something right. Square Inc (NYSE:SQ) stock has soared. The Square stock price has more than doubled since SQ earnings for Q4 were released back in February. SQ stock now has risen about 250% from its IPO price back in November 2015, after an offering that was widely viewed as a disappointment.

SQ stock investors aren’t disappointed, obviously, but there are real reasons for the optimism toward SQ stock at the moment. The company continues to grow revenue nicely. Volume from larger sellers (over $500K in annual payments) is growing even faster. Square is starting its own bank, and its increasing amount of service offerings beyond payment processing are growing sales and helping margins.

Still, valuation matters, and the Square stock price looks just too high. I thought SQ stock looked overvalued after admittedly strong Square earnings for Q2. SQ stock has tacked on another 20% worth of gains since. All but perfection looks priced in at this point, and with competition intensifying, that makes Square stock a risky play.

The Square Stock Price

With an enterprise value near $11 billion, Square stock trades for over 11x the company’s adjusted revenue guidance for 2017. It’s a big number, even in a payments industry that is seeing high valuations. For instance, industry leader Paypal Holdings Inc (NASDAQ:PYPL) trades at about 6x. And while Shopify Inc (US) (NYSE:SHOP) trades at 14x, it’s growing much faster than Square (75% growth in its Q2, against the 41% adjusted increase cited in Square earnings). And even at that multiple, I like SHOP stock after last week’s short-seller-driven drop.

But 11x sales seems like too much to pay for SQ stock, particularly with the company still basically unprofitable. Adjusted EBITDA is guided to clear $120 million this year, but that figure excludes stock-based compensation which is on track to total $140 million. Backing out that dilution of Square stock, Square isn’t making “real” profits, yet.

Valuation simply is too large a concern at this point, even though Square has a solid growth case. I like that case for Square as a company. I just don’t like the Square stock price, at least not above $30.

The Bull Case for SQ Stock

There’s two clear reasons for optimism regarding Square stock. The first is the company’s quickly expanding base of services. The Wall Street Journal reported last month that Square had filed to create a wholly owned bank. That entity, to be named Square Financial Services, will allow the company to move into business lending. Square already offers instant deposits (for a fee), along with loans and financing through Square Capital, run through a partnership with Utah-based Celtic Bank.

Square Cash offers P2P payments, creating a potential rival to Paypal unit, Venmo. And the legacy POS business is growing nicely, with gross payment volume rising 32% in Q2, and 45% at larger sellers in the quarter.

There remain a few ways for Square to grow revenue. And as the company matures, margins will expand, hopefully driving substantial profits. Square likely isn’t going to reach the 60%+ operating margins driven by Visa Inc (NYSE:V), but even 20%+ on a $2-billion revenue base a few years out suggests the company could generate $500 million in pre-tax earnings, or around $1 per share in EPS. From there, Square still should have years of growth in front of it, as it penetrates international markets and increases share.

The second potential driver for SQ stock is an acquisition. Square long has been considered a takeover target, and rumors that Paypal wants to buy the company persist. And there’s little doubt M&A speculation has played at least some part in the recent run.

Square Stock Remains Overvalued

Both drivers of the bull case appear intact, but they also appear priced in. Even assuming $1 per share in EPS by 2020, SQ stock still trades at over 30x that figure and would have to trade at something closer to 40x to generate reasonable annual returns until then. Meanwhile, the M&A case gets tougher as Square stock climbs higher. Is Paypal, or anyone else, really going to pay 15x sales, even given Square’s top-line growth?

And there’s another key concern here: competition. Shopify recently released its own point of sale reader. Privately held Stripe is a worthy competitor. Vantiv Inc (NYSE:VNTV) is trying to create a trans-Atlantic powerhouse with its acquisition of Worldpay Group. A KeyBanc survey suggests that 60% of Square’s large sellers have already been offered lowered prices, a figure that is likely to increase going forward as competition intensifies.

Square so far has held off most of those rivals, and it likely will do so going forward. But competition could hit pricing, which in turn would pressure margins and undercut the bull case for Square stock.

It’s not as if Square is going bankrupt, by any means, and it’s likely growth will continue. After the big run in SQ stock, the question is how much growth is needed just to support the current Square stock price? And it appears at this point that even a growing Square might not be able to drive the earnings increases investors are pricing in.

As of this writing, Vince Martin has no positions in any securities mentioned.